EFFECTIVE INTEREST METHOD

Market price of bonds

AC 1201
• PFRS 9 requires that discount on bonds payable, premium on bonds payable and bond
issue cost shall be amortized using the effective interest method.
• This method distinguishes two kinds of interest rates, namely:
• 1. Nominal rate is the coupon or stated rate
• 2. Effective rate is yield or market rate
• The effective rate is the rate that exactly discounts estimated cash future payments
through the expected life of the bonds payable or when appropriate, a shorter period to
the net carrying amount of the bonds payable.
• When bonds are sold at a premium, the effective rate is lower than the nominal rate.
• When bonds are sold at a discount, the effective rate is higher than the nominal rate.
• Effective interest method
• Under the effective interest method, the effective interest expense is determined by
multiplying the effective rate by the carrying amount of the bonds.
• The carrying amount of the bonds changes every year as the amount of premium or
discount is amortized periodically.
• Discount amortization = Effective interest - Nominal interest

• Interest paid = Face amount x nominal rate

• Interest expense = Carrying amount x effective rate
• Discount amortization = Interest expense – interest paid
• Carrying amount = preceding carrying amount + discount amortization
• Illustration: Effective amortization of discount
• On January 1, 2020, an entity issued two-year 8% bonds with face amount of P1,000,000 for
P964,540, a price which will yield a 10% effective interest cost per year. Interest is payable
semiannually on June 30 and December 31.
• Interest Interest Discount Carrying
• Date paid expense amortization amount
• Jan.1, 2020 964,540
• June 30, 2020 40,000 48,227 8,227 972,767
• Dec. 31, 2020 40,000 48,638 8,638 981,405
• June 30, 2021 40,000 49,070 9,070 990,475
• Dec. 31, 2021 40,000 49,525 9,525 1,000,000
• Journal entries for 2020:
• 1/1/20 – Issuance of bonds.
• Cash 964,540
• Discount on bonds payable (1,000,000 – 964,540) 35,460
• Bonds payable (at face amount) 1,000,000
• 6/30/20 – Payment of semiannual interest and discount amortization for 6 months.
• Interest expense 48,227
• Cash (1,000,000 x 8% x 6/12) 40,000
• Discount on bonds payable (See table of amortization) 8,227
12/31/20 – Payment of semiannual interest and discount amortization for 6 months.
• Interest expense 48,638
• Cash (1,000,000 x 8% x 6/12) 40,000
• Discount on bonds payable (see table of amortization) 8,638
• Note: Payment of semiannual interest and the periodic amortization of the discount are
compounded in one entry. This items can be recorded separately.
• Effective amortization of premium
• Premium amortization = Nominal interest – Effective interest
• Interest paid = Face amount x nominal rate
• Interest expense = Carrying amount x effective rate
• Premium amortization = Interest paid – interest expense
• Carrying amount = Preceding carrying amount – premium amortization
• Illustration:
• On January 1, 2020, an entity issued three-year 12% bonds with face amount of P1,000,000 for
P1,049,740, a price which will yield a 10% effective interest cost per year. The interest is payable
annually every December 31.
• Interest Interest Premium Carrying
• Date paid expense amortization amount
• Jan. 1, 2020 1,049,740
• Dec. 31, 2020 120,000 104,974 15,026 1,034,714
• Dec. 31, 2021 120,000 103,471 16,529 1,018,185
• Dec. 31, 2022 120,000 101,815 18,185 1,000,000
• Journal entries for 2020 and 2021:
• 1/1/20 – Issuance of bonds.
• Cash 1,049,740
• Premium on bonds payable 49,740
• Bonds payable (at face amount) 1,000,000
• 12/31/20 – Payment of annual interest.
• Interest expense 120,000
• Cash (1,000,000 x 12%) 120,000
• 12/31/20 - Premium amortization for 1 year.
• Premium on bonds payable (See table of amortization) 15,026
• Interest expense 15,026
• 12/31/21 – Payment of annual interest.
• Interest expense 120,000
• Cash (1,000,000 x 12%) 120,000
• 12/31/21 – Premium amortization
• Premium on bonds payable (See table of amortization) 16,529
• Interest expense 16,529
• Note: The annual payment of interest and the premium amortization are recorded separately for 2020 and 2021.
• Market price or issue price of bonds payable
• The market price or issue price of bonds payable is equal to the present value of the
principal bond liability plus the present value of the future interest payments using
the effective or market rate of interest.
• The present value of the principal bond liability is equal to the face amount of the
bond multiplied by the present value of 1 factor at the effective rate for a number of
interest periods.
• The present value of the future interest payments is equal to the periodic nominal
interest multiplied by the present value of an ordinary annuity of 1 factor at the
effective rate for a number of interest periods.
• In other words, the market price of bonds payable is equal to the sum of the
following:
• a. Present value of bonds payable (face amount of bonds x PV of 1 factor)
• b. Present value of the total interest payments (Periodic nominal interest x PV of an
ordinary annuity of 1 factor)
• Illustration 1: Interest is payable annually
• Face amount of bonds 4,000,000
• Nominal rate 6%
• Effective rate 8%
• The bonds are issued on January 1, 2020 and mature in four years on January 1, 2024. The interest is payable
annually every December 31.
• PV of 1 at 8% for 4 periods .7350
• PV of an ordinary annuity of 1 at 8% for 4 periods 3.3121
• Required: What is the present value of the bonds?
• Answer: Present value of the principal (4,000,000 x .7350) 2,940,000
• Present value of annual interest payments (240,000 x 3.3121) 794,904
• Present value of the bonds 3,734,904
• Interest Interest Discount Carrying
• Date paid expense amortization amount
• Jan. 1 , 2020 3,734,904
• Dec. 31,2020 240,000 298,793 58,792 3,793,696
• Dec. 31, 2021 240,000 303,496 63,496 3,857,192
• Dec. 31, 2022 240,000 308,575 68,575 3,925,767
• Dec. 31, 2023 240,000 314,233 74,233 4,000,000
• Illustration 2: Interest is payable semiannually
• Face amount of bonds 5,000,000
• Nominal rate 12%
• Effective rate 10%
• The bonds are issued on January 1, 2020 and mature in 3 years on January 1, 2023. The
interest is payable semiannually. The PV factors using the semiannual effective rate are:
• PV of 1 at 5% for 6 periods .7462
• PV of an ordinary annuity of 1 at 5% for 6 periods 5.0757
• Required: What is the present value of the bonds?
• Answer: PV of principal (5,000,000 x .7462) 3,731,000
• PV of interest payment (300,000 x 5.0757) 1,522,710
• Total present value of bonds 5,253,710
• Note: The semiannual interest payment of P300,000 is computed by multiplying the face
amount of P5,000,000 by the semiannual nominal rate of 6% (12% / 2).
• Table of amortization next page.
• Interest Interest Premium Carrying
• Date paid expense amortization amount
• Jan. 1 2020 5,253,710
• June 30, 2020 300,000 262,686 37,314 5,216,396
• Dec. 31, 2020 300,000 260,820 39,180 5,177,216
• June 30, 2021 300,000 258,861 41,139 5,136,077
• Dec. 31, 2021 300,000 256,804 43,196 5,092,881
• June 30, 2022 300,000 254,644 45,356 5,047,525
• Dec. 31, 2022 300,000 252,475 47,525 5,000,000
• Illustration 3: Serial bonds
• Face amount of bonds 3,000,000
• Nominal rate 12%
• Effective rate 10%
• Date of issue January 1, 2020
• Annual payment every December 31 1,000,000
• Interest is payable annually December 31
• Present value of 1 at 10%: One period 0.9091
• Two periods 0.8264
• Three periods 0.7513
• Required: What is the present value of serial bonds?
• Answer: (a) (b) (a x b)
• Principal Interest Total PV Present
• Date payment payment payment factor value
• 12/31/20 1,000,000 360,000 1,360,000 0.9091 1,236,376
• 12/31/21 1,000,000 240,000 1,240,000 0.8264 1,024,736
• 12/31/22 1,000,000 120,000 1,120,000 0.7513 841,456
• Total present value of serial bonds 3,102,568
• Less: Face amount 3,000,000
• Premium on bonds payable 102,568
• Interest Interest Premium Principal Carrying
• Date paid expense amortization payment amount
• 1/1/2020 3,102,568
• 12/31/2020 360,000 310,257 49,743 1,000,000 2,052,825
• 12/31/2021 240,000 205,282 34,718 1,000,000 1,018,107
• 12/31/2022 120,000 101,893 18,107 1,000,000 0
• Journal entries for 2020 and 2021:
• 1/1/2020 – Issuance of bonds.
• Cash 3,102,568
• Premium on bonds payable 102,568
• Bonds payable (at face amount) 3,000,000
• 12/31/20 – Payment of annual interest.
• Interest expense 360,000
• Cash (3,000,000 x 12%) 360,000
• 12/31/20 – Amortization of premium for 2020.
• Premium on bonds payable (See table of amortization) 49,743
• Interest expense 49,743
• 12/31/20 – First annual payment of principal.
• Bonds payable 1,000,000
• Cash 1,000,00 0
• 12/31/21 – Payment of annual interest.
• Interest expense 240,000
• Cash (2,000,000 x 12%) 240,000
• 12/31/21 – Amortization of premium for 2021and second annual payment of principal.
• Premium on bonds payable (See table or amortization) 34,718
• Interest expense 34,718
• Bonds payable 1,000,000
• Cash 1,000,000
• Effective interest method – bond issue cost
• PFRS 9 provides that transaction costs that are directly attributable to
the issue of financial liability shall be included in the initial
measurement of financial liability.
• Transaction costs are fees and commissions paid to agents, advisers,
brokers and dealers, levies by regulatory agencies and security
exchange, and transfer taxes and duties. Transaction costs include bond
issue costs.
• These bond issue costs will increase discount on bonds payable and will
decrease premium on bonds payable.
• Under the effective interest method, bond issue cost must be “lumped”
with the discount on bonds payable and “netted” against the premium
on bonds payable.
• Illustration 1: Discount and bond issue cost
• On January 1, 2020, an entity issued three-year bonds with face amount of P10,000,000
and 9% stated rate.
• The bonds mature on January 1, 2023 and interest is payable annually on December 31.
• The bonds are issued at P9,751,210 with an effective yield of 10% before considering the
bond issue cost.
• The entity paid bond issue cost of P239,880.
• Face amount 10,000,000
• Discount on bonds payable 248,790
• Issue price 9,751,210
• Bond issue cost 239,880
• Net proceeds 9,511,330
• Note: The effective rate is 10% but because of the bond issue cost, the effective rate must
be higher than 10%. The problem is to find an effective rate that will equate the present
value of the cash outflows for the bonds payable to the net proceeds of P9,511,330.
• The effective rate cannot be computed algebraically but by means of trial and error or the interpolation process.
• By trial and error, using a new effective rate of 11%:
• Present value of 1 for 3 periods is - .7312
• Present value of an ordinary annuity of 1 is – 2.4437
• The present value of the bonds payable using an interest rate of 11% is computed as follows:
• PV of principal (10,000,000 x .7312) 7,312,000
• PV of interest payments (900,000 x 2.4437) 2,199,330
• Total present value of bonds 9,511,330
• Journal entries for 2020:
• 1/1/2020 – Issuance of bonds.
• Cash (10,000,000 – 248,790 – 239,880) 9,511,330
• Discount on bonds payable (248,790 + 239,880) 488,670
• Bonds payable (at face amount) 10,000,000
• 12/31/20 – Payment of annual interest and discount amortization using effective interest method.
• Interest expense (10,000,000 x 9%) 900,000
• Cash 900,000
• Interest expense 146,246
• Discount on bonds payable (9,511,330 x11%) - (10,000,000 x 9%) 146,246
• Illustration 2: Discount (with no effective rate) and bond issue cost
• On January 1, 2020, an entity issued 5-year bonds with face amount of P10,000,000 at 95.
• The nominal rate is 10% and the interest is payable annually on December 31.
• The bonds mature on January 1, 2025. The entity paid bond issue cost of P200,000.
• Face amount 10,000,000
• Discount on bonds payable 500,000
• Issue price (10,000,000 x .95) 9,500,000
• Bond issue cost 200,000
• Net proceeds 9,300,000
• Again, the problem is to find an effective rate applicable to the proceeds of P9,300,000.
Since, the bonds are issued at a discount, the effective rate must be higher than nominal
rate of 10%.
• By interpolation, using a rate of 11%, the PV of 1 for 5 periods is .5935 and the PV of an
ordinary annuity of 1 is 3.6959. The total present value of bonds would be P9,630,900.
(continue next slide)
• The net proceeds of P9,300,000 are lower than the present value of bonds payable of P9,630,900 using 11%
interest rate. This means that the effective rate must be higher than 11%.
• So, another interpolation is made using the rate of 12%. The PV of 1 for 5 periods at 12% is .5674. The PV of an
ordinary annuity of 1 for 5 periods at 12% is 3.6048. Thus, the total present value of bonds would be P9,278,800.
• This time, the net proceeds of P9,300,000 are higher than the present value of bonds payable of P9,278,800 using
12% interest rate. This means that the effective rate must be lower than 12%.
• In conclusion, the effective interest rate must be between 11% and 12%.
• The difference between 11% and 12% is interpolated as follows:
• Let X as the unknown effective interest rate
• (X – 11%) / (12% - 11%)
• (9,300,000 – 9,630,900) / (9,278,800 – 9,630,900)
• 330,900 / 352,100 = 0.94
• This difference of .94 between 11% and 12% is added to 11% to get an effective rate of 11.94%.
• Thus, the PV of 1 for 5 periods at 11.94 % effective rate is .56895 and the PV of an ordinary annuity of 1 for 5
periods at 11.94% effective rate is 3.61014. The present value of bonds is computed as follows:
• PV of principal (10,000,000 x .56895) 5,689,500
• PV of interest payments (1,000,000 x 3.61014) 3,610,140
• Total present value of bonds 9,299,840 or 9,300,000
• Illustration 3: Premium ( with no effective rate) and bond issue cost
• On January 1, 2020, an entity issued 5-year bonds with face amount of P10,000,000 at 105. The nominal rate is
10% and the interest is payable annually on December 31.
• The bonds mature on January 1, 2025. The entity paid bond issue cost of P200,000.
• Face amount 10,000,000
• Premium on bonds payable (10,000,000 x .05) 500,000
• Issue price (10,000,000 x 1.05) 10,500,000
• Bond issue cost ( 200,000)
• Net proceed 10,300,000
• 1/1/2020 – Issuance of bonds.
• Cash 10,300,000
• Premium on bonds payable (500,000 – 200,000) 300,000
• Bonds payable (at face amount) 10,000,000
• Since the bonds are issued at a premium, the effective rate must be lower than 10% nominal rate.
• By interpolation, using a rate of 9%, the PV of 1 for 5 periods is .6499 and the PV of an ordinary annuity of 1 is
3.8897. The present value of bonds would be P10,388,700
• The net proceeds of P10,300,000 are lower than the present value of bonds payable of P10,388,700 using a 9%
effective interest rate. This means that the effective rate must be higher than 9%.
• In conclusion, the effective rate must be between 9% and 10%. (Continue next slide)
• The differential rate between 9% and 10% is interpolated as follows:
• Let X as the unknown effective rate
• (X - 9%) / (10% - 9%)
• (10,300,000 -10,388,700) / (10,000,000 – 10,388,700)
• 88,700 / 388,700 = .23
• Thus, the effective interest rate is 9.23% (9% + .23)
• Therefore, the PV of 1 for 5 periods at 9.23% effective rate is .64312 and the PV of an ordinary annuity of 1
for 5 periods at 9.23 % effective rate is 3.86655. The present value of bonds is computed as follows:
• PV of principal (10,000,000 x .64312) 6,431,200
• PV of interest payments (1,000,000 x 3.86655) 3,866,550
• Total present value of bonds 10,297,750 or: 10,300,000
• 12/31/20: Payment of annual interest.
• Interest expense (1,000,000 x 10%) 1,000,000
• Cash 1,000,000
• Premium on bonds payable (1,000,000 – 950,690) 49,310
• Interest expense 49,310
• Note: Interest paid (10,000,000 x 10%) = 1,000,000
• Interest expense (10,300,000 x 9.23%) = 950,690
• Problem 1:
• On December 31, 2020, Dome Co. issued P4,000,000, 8% serial bonds, to be repaid in the amount of
P800,000 each year. Interest is payable annually on December 31. The bonds were issued to yield 10%
a year.
• The bond proceeds totaledP3,805,600 based on the based on the present value on December 31,
2020 of five annual installments:
• Due date Principal payment Interest PV on 12/31/21
• 12/31/2021 800,000 320,000 1,018,000
• 12/31/2022 800,000 256,000 872,200
• 12/31/2023 800,000 192,000 745,000
• 12/31/2024 800,000 128,000 633,800
• 12/31/2025 800,000 64,000 536,600
• 3,805600
• Required:
• 1. Determine the carrying amount of the bonds payable on December 31, 2021 using the interest
method of amortizing bond discount.
• 2. Prepare journal entries for 2021.
• Answer:
• 1. Interest expense - 2021 (3,805,600 x 10%) 380,560
• Interest paid - 2021 (4,000,000 x 8%) 320,000
• Discount amortization 60,560
• Bonds payable (at face amount) 4,000,000
• Issue price (bond proceeds) 3,805,600
• Discount on bonds payable 194,400
• Less: Discount amortization 60,560
• Balance of discount on bonds payable 133,840
• Balance of bonds payable – December 31, 2021 (4,000,000 – 800,000) 3,200,000
• Less: Balance of discount on bonds payable, 12/31/21 133,840
• Carrying amount of bonds payable – 12/31/21 3,066,160
• 2. 12/31/2020 – Issuance of bonds.
• Cash 3,805,600
• Discount on bonds payable (4,000,000 – 3,805,600) 194,400
• Bonds payable (at face amount) 4,000,000
• 12/31/2021 – Payment of annual interest.
• Interest expense (4,000,000 x 8%) 320,000
• Cash 320,000
• 12/31/2021 – Amortization of discount
• Interest expense 60,560
• Discount on bonds payable (380,560 – 320,000) 60,560
• 12/31/2021 – 1st payment of principal.
• Bonds payable 800,000
• Cash 800,000

• Problem 2:
• On July 1, 2020, Tara Company issued 4,000 bonds of 8%, one thousand face amount for
P3,504,000. The bonds were issued to yield 10%. The bonds are dated July 1, 2020 and mature
on July 1, 2029. Interest is payable semiannually on January 1 and July 1.
• Required: What amount of the bond discount should be amortized for the six months ended
December 31, 2020?
• Answer: Interest expense (3,504,000 x 10% x 6/12) 175,200
• Interest paid ( 4,000,000 x 8% x 6/12) 160,000
• Discount amortization for 6 months 15,200
• Problem 3:
• On January 1, 2020, Wolf company issued 10% bonds in the face amount of P5,000,000, which mature on
January 1, 2030. The bonds were issued for P5,675,000 to yield 8%, resulting in the premium of P675,000.
• The entity used the interest method of amortizing bond premium. Interest is payable annually on
December 31.
• Required:
• 1. What is the balance of the premium on bonds payable on December 31, 2020?
• 2. What is the carrying amount of bonds payable on December 31, 2020?
• Answers:
• 1. Interest paid – 12/31/20 (5,000,000 x 10%) 500,000
• Interest expense – 12/31/20 ( 5,675,000 x 8%) 454,000
• Premium amortization 12/31/20 46,000
• Premium on bonds payable (5,675,000 – 5,000,000) 675,000
• Less: Premium amortization – 12/31/20 46,000
• Balance of the premium on bonds payable – 12/31/20 629,000
• 2. Carrying amount of bonds payable on 12/31/20:
• 5,000,000 + 629,000 = 5,629,000
• Problem 4:
• Nixon Company reported 10% bonds payable with carrying amount of P5,700,000 on January 1, 2020. The
bonds had a face amount of P6,000,000 and were issued to yield 12%.
• The interest method of amortization is used. Interest was paid on January 1 and July 1 of each year
• On July 1, 2020, the entity retired the bonds at 102. The interest payment on July 1, 2020 was made as
scheduled.
• Required:
• 1.What is the carrying amount of bonds payable on July 1, 2020?
• 2. What amount should be recorded as loss on the early extinguishment of the bonds?
• Answers:
• 1. Interest expense (5,700,000 x 12% x 6/12) 342,000
• Interest paid (6,000,000 x 10% x 6/12) 300,000
• Discount amortization – 7/1/2020 42,000
• Add: carrying amount – 1/1/2020 5,700,000
• Carrying amount of bonds payable – 7/1/2020 5,742,000
• 2. Carrying amount of bonds payable -7/1/2020 5,742,000
• Less; Retirement price (6,000,000 x 1.02) 6,120,000
• Loss on the early retirement of bonds 378,000